How can novice investors beat wall street?
Updated: Oct 25, 2020
The COVID-19 pandemic has put a brake on the global economy. Many non-essential businesses are closed and people lost their jobs. Reflecting these devastating damages to the economy, the US stock market has recently gone through the steepest decline and recovery in its history.
During the rapid fall of the stock market, many investors sell their stocks with loss, fearing that holding on to them would incur more losses over time. People who don't own stocks may feel relieved, thinking that it is better not to invest in stocks after all.
I think of investment as a vehicle that expedites social mobility by giving easy access to people who don't run their own businesses. In this blog post, I will talk about what I have learned from my investment experience for those interested in investing without knowing where to start. Hopefully, this article will help you decide how to make the best use of your savings. For a guide to plan your retirement funding, you can read another post here.
(Image source: Media Source Repository System)
Let me start with my biggest mistake. After learning about the benefits of IRA accounts, I opened one in 2015. Not knowing how to invest, I bought the maximum number of shares of an index fund AT ONCE with what I was allowed to contribute to this account for 2 years. It was March of 2015. Guess what? The stock market went south right after that, which shrank the balance of my investment account by 10% immediately. Because I could not buy more shares during this market correction due to the annual contribution limit, it took a year for my portfolio to break even. Had I spread my contributions throughout a year including when the share price of my index fund was cheaper, I would have recovered from a 10% loss much faster.
That is how I realized the importance of dollar-cost-averaging. The beauty of dollar-cost-averaging is that there is no need to pay attention to how the stock market is doing. To make the best use of dollar-cost-averaging, I invest the same amount of cash bi-weekly in index funds that hold the biggest 500 companies in the United States (S&P500). Once I set up an automatic investment, the rest is taken care of. This is how I manage my retirement accounts hassle-free.
Index funds are the most convenient investment vehicle I can think of, which makes it suitable for regular investments from paychecks. What about investing in individual stocks? Can we expect better returns from high-performing stocks than index funds? Yes, in theory.
It is not easy to realize high returns from investing in great businesses though. First, we need to pick high-performing stocks by predicting which companies will continue to thrive in their businesses for the next ten years. Second, we need to hang on to these stocks through market downturns as long as the economic fundamentals of the underlying businesses stay strong. As you can imagine, it takes a lot more effort to achieve market-beating returns from individual stocks. However, it is also fun to keep an eye on the businesses of your interest. My trials and errors from investing in 100 stocks for the last three years have taught me that it is better to invest a small proportion of my savings in a few stocks when I find promising businesses that I enjoy using.
My inspiration for investing in stocks has come from Peter Lynch, a legendary investor who wrote "One Up on Wall Street". I learned the most valuable investment lessons from this book that is quite entertaining as well. If you are looking for the first investment book, this is it. I highly recommend it. Peter talks about the best way for amateur investors like you and me to succeed in investing. It is simple enough for anyone to adopt: pay attention to the businesses that are thriving right in front of your eyes before they grow big enough for professional investors on Wall Street to notice. By following Peter's advice, I was able to spot a couple of promising businesses that continue to grow fast.
(Image source: squareup.com)
When I was traveling on a business trip in 2017, something caught my eyes in a taxi. When I handed my credit card over to the taxi driver, he pulled up his phone and installed a tiny card reader on it to charge my credit card. When asked for the receipt, the taxi driver told me to type my email address on the phone and press 'send'. It was my first 'seamless' credit card transaction that happened in a taxi. I was quite impressed with it and learned that the taxi driver had been quite enjoying this service. Later, I ran into the same credit card readers at a small healthcare provider and restaurants.
The service provider turned out to be a tech company called Square that aims to empower small business owners by providing them platforms for credit card processing, customer feedback, accounting, eCommerce, online delivery, and loans. Technology services for small business owners. It was a new niche business that has a huge addressable market. And customers were loving it. Square seemed to check many boxes for a great investment opportunity. Square was not well known to Wall Street then and analysts were not covering it much. I purchased 40 shares at $25 per share in 2017 and its share price quadrupled in a year. There have been ups and downs since 2018, but Square has been continuously expanding its market share. I'm still happily investing in its business for the long haul. Now SQ is one of the most popular stocks.
(Image source: progressive.com)
Another investment opportunity that knocked on my door was Progressive, an insurance company. When I was living in Michigan, I went with a different insurance company just because everyone I knew was using it. But I became unhappy with its poor customer service and high insurance fee for my very infrequent driving. After a long search process, I found an online insurance company called Progressive. Not only was everything streamlined online, but they also based their insurance charge on scientific assessments of risks for potential driving accidents. To achieve this goal, they ask their customers to install a device that monitors their driving habits. When and how often do the customers drive their cars? Do they brake abruptly, which would increase the risks of car accidents? Because I usually drive early on weekend mornings, when there is not much traffic, I ended up paying a discounted insurance fee. That is an innovation for the insurance industry! Since I"m a happy customer, it was not difficult to predict that Progressive will satisfy many more customers who might be on the lookout for better insurance services. I became a shareholder of Progressive in 2017 and its share price has nearly doubled since then.
You can do the same thing to become a stock investor. Do you love your phone and computer? Which companies are making memory chips, operating systems, and hardware? Where do you do your online shopping the most? Which search engine can you not live without? Which company performs the best in your industry? While you are answering similar questions, you will definitely find promising businesses you enjoy using.
(Image source: Media Source Repository System)
When I list high-performing stocks in my portfolio, they show recent trends in thriving businesses: eCommerce, online advertisement, process automation, renewable energy, software-as-a-service (subscription model), online platforms that connect sellers and buyers, and artificial intelligence. Stock investment has encouraged me to take another look at the world from the perspectives of economists. It also helped me understand what the future would look like and how I can prepare for it. If I had learned about investment at school, I would have enjoyed economy classes so much more and been financially independent by now!
Just because I have some high-performing stocks in my portfolio, it does not mean that I have been right about the prospect of each business 100% of the time. It is far from the truth. 37% of my stocks have lost 10-80% of their share values since I purchased them. Despite poor performances of these loser stocks, my stock portfolio has been outperforming my index funds because 25% of my stocks have quickly gained their share prices multiple times. Looking back, had I only purchased stocks whose underlying businesses I have used as a consumer or worked for as an employee, my stock portfolio would have more winners and fewer losers. When we can watch those businesses closely, not only can we spot promising businesses early, we can also tell when they start to deteriorate. That is when we need to sell those stocks to cut our losses early.
The growth potential of high-quality stocks is unlimited while the maximum loss from loser stocks is limited. You cannot lose more than what you have invested. On the other hand, best-performing stocks can bring in 10 times more profits than your investment cost in the long run. For example, the share price of my best performer SHOP has grown 800% in 3 years. That is why we need to focus on long-term gain rather than the purchase price. When I bought the first batch of SHOP at $90 per share in 2017, I regretted that I had not bought them at $40 per share just a couple of months earlier. While the difference seemed quite large between $40 and $90 at the time of purchase (225%), with its current stock price ($760), the difference is only 7% now. But it is noteworthy that I had not seen much change in the share price of SHOP for the first two years before it started growing exponentially last year.
Long-term investors need to be patient to realize potential gains from their stock investment. If you look at the performance history of my stock portfolio, which is shown below, you can see that it has lost all gains during the market downturns and recovered from them twice for the last three years. So, investing in stocks is not for the faint of heart.
(3-year performance of a portfolio composed of 80 stocks)
Then, how can we deal with the volatility of the stock market? You may think that it would be best to sell all the stocks at the peak and buy them all back at the bottom. The problem is that it is nearly impossible to tell the peak and trough of the stock market in real-time. Even experts don't realize the bottom of a bear market until the stock market has already climbed a halfway back to its previous peak.
My strategy is to maintain long-term investments regardless of how the stock market does. History shows that it pays to stay in the stock market through its downturns. If you miss the five best days, you could lose 35% of your capital gain from a 38-year investment (see the chart below). It also helps to know that the steeper the downturn of the stock market is, the faster its recovery will be.
You can even take advantage of the stock market downturns. To make the best use of dollar-cost-averaging, it makes sense to purchase more shares of index funds on every 10% dip or deeply discounted stocks when opportunities present themselves. Because the stock market is not efficient and often run by investors' emotions, you can wait for a specific stock to go on sale even when the overall economy is booming. Sometimes a bad rumor alone is enough to tank the share price of a stock because many investors sell their stocks in a panic. If you know that the fundamentals of the underlying business have not changed, you can buy these stocks on sale, expecting a fast capital gain from this purchase.
If you have never invested before, I suggest that you invest the same amount of cash in an index fund every month while keeping your eyes open for promising businesses around you. When you find one, you can purchase a small number of shares of the stock associated with the business and add more shares when the stock goes on sale.
I hope that this blog post has piqued your interest in investment. If you have questions about how to start investing, you can leave your comments below. I will be happy to answer them as best as I can. Happy investing!